SUBMISSION FROM THE BUILDING SOCIETIES ASSOCIATION
Introduction
1. The Building Societies Association (BSA) represents mutual lenders and deposit takers in the UK, including all 52 UK building societies. Building societies (as at the end of July 2009) have total assets of over £370 billion and, together with their subsidiaries, hold residential mortgages of over £245 billion, more than 20% of the total outstanding in the UK. Societies hold nearly £240 billion of retail deposits, accounting for more than 20% of all such deposits in the UK. Building societies also account for about 36% of all cash ISA balances. Building societies employ approximately 50,000 full and part-time staff and operate through approximately 2,000 branches.
2. The Building Societies Association is a UK-wide body, with members in Scotland, England, Wales and Northern Ireland. It works from a single office in London. It views the banking market (broadly defined to include building societies) from a UK perspective and has no particular insights into the banking markets of England, Wales, Northern Ireland or, indeed, Scotland. The bulk of this evidence therefore covers the UK market, although references are made to the building society sector in Scotland. Accordingly, this evidence does not specifically answer the key questions posed by the Committee in a Scottish context. However, many of the points made in respect of the UK will have an impact on activity in Scotland in the same way as the other countries of the United Kingdom.
Building Societies in Scotland
3. Until earlier this year, there were three building societies based in Scotland. Their total assets at the end of 2007, the latest year for which information is available, were as follows.
Assets of Scottish Based Building Societies, End 2007, £ million
Dunfermline 3,303
Scottish 259 (31 January 2008)
Century 22
4. By 31 January 2009 the assets of the Scottish Building Society had grown to £296 million, by 31 December 2008 the assets of the Century Building Society had reached £24 million. As is well known, the Dunfermline Building Society did not distribute an annual report describing its financial position as at the end of 2008. This evidence does not dwell on circumstances leading to that situation. The Scottish Affairs Committee of the UK Parliament has published a comprehensive report on this matter that can be found at http://www.publications.parliament.uk/pa/cm200809/cmselect/cmscotaf/548/54802.ht m
Brief History of Building Societies in Scotland
5. There had been just three building societies based in Scotland for a number of years. The Dunfermline Building Society had merged with, at least, nine other
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Scottish societies since 1945, but the last of these (with the Edinburgh and Paisley Building Society) occurred in May 1981. The Scottish Building Society has absorbed 10 other societies since 1945; the last of these involved the transfer of engagements of the Huntly Building Society to the Scottish in November 1985. The Century Building Society has never been involved in merger activity.
6. Historically, the Scottish building society sector was relatively smaller than that in the rest of the United Kingdom. This has likely to have been the result of –
(a) A relatively strong trustee savings bank movement in Scotland. Indeed, the TSBs were founded initially in Scotland, the first being established in 1810.
(b) The historically, relatively low level of owner-occupation in Scotland. In recent years the level of owner-occupation in Scotland has grown rapidly; however in the pre and post war period it was much lower than in the rest of the United Kingdom, thus leading to a relatively low demand for mortgages in Scotland.
In other words strong competition on the liability (savings) side of the balance sheet and a relative absence of demand on the asset (mortgage) side of the balance sheet led to relatively low levels of building society activity in Scotland. Unlike in the banking sector, that activity that did take place was dominated by English-based building societies in the final decades of the 20th century. As at the end of 2008, it is estimated that seven English-based societies operate in Scotland.
Causes, Nature and Impact of the Boom and Recession
The Boom
7. The extraordinary events of the last two years have tested the analytical powers of the most eminent and well informed economists, regulators, politicians, journalists and financiers. However, in the view of The Building Societies Association, the key elements of the financial crisis lay in the components of the boom conditions that existed in one form or another from the mid to late 1990s until mid 2007 –
• A relaxation of credit underwriting standards
• The development of a borrowing culture on the part of customers, institutions and Government
• Firms moving away from their traditional businesses
• Expectations of continued house price inflation
• Over-extended funding lines, amidst expectations of continued large flows of cheap wholesale funding
• A confusion of dispersion of risk with reduction of risk. In particular, securitisation allowed loan originators to remove risk from their balance sheets, without there being sufficient recognition that it ended up elsewhere in the system.
• Unrecognised concentration risk
• Lack of transparency in the packaging of certain wholesale instruments
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• Pro-cyclical capital requirements – ie Basel II encouraged a reduction in capital holding in the run up to what emerged as recession.
• Perverse incentives, particularly in the remuneration and bonus payment areas
• Greed, arrogance and an over-emphasis on growth on the part of some institutions.
8. It is worth emphasising that these are characteristics observed across the market, not in every firm; many building societies (and a number of banks), for example, avoided most or all of the issues described above.
9. The bust from August 2007 was characterised by the unwinding of some of the attributes of the boom period itemised above. However, the bust also featured a range of other factors –
(i) A rapid decline.
10. The rapidity of the change in economic and financial conditions took most by surprise. For example - • House prices fell by 20% in the first 18 months of the recession. In the 1990s there was a decline of this magnitude, but over four years.
• Wholesale money markets “froze” from August 2007, with activity coming to a sudden halt, rather than conditions gradually deteriorating.
• In late July 2007, the Northern Rock interim results for the first half of the year opened with an optimistic statement from the Chief Executive. Six weeks later depositors were queuing up to withdraw funds. This reflected the rapid deterioration in Northern Rock’s wholesale funding position.
• Marking elements of the balance sheet to market probably transmitted changes within some poorly placed institutions more widely, more rapidly, to other institutions than expected.
• Rating agencies were quick to alter their views on particular institutions.
• New technology enabled information - and rumour - to be transmitted more rapidly, than in the past, between market participants.
(ii) The Extent of the Crisis
11. Once the crisis had started it affected a far wider range of institutions and countries than anyone had anticipated. Indeed, the crisis showed that institutions, markets and countries had become integrated to a previously unrecognised extent.
12. Moreover, the extent of market punishment of institutions had no respect for the previous reputation, size, or nature of an institution. In the USA Fannie Mae and Freddie Mac, previously viewed as very solid, along with some of the greatest names in investment banking, failed to survive as independent entities. In the UK, what used to be called, in its building society days, the “Mighty Halifax” required Government assistance, as did the Royal Bank of Scotland, earlier believed to be an
3 outstanding success story. Despite their relatively good performance, mutuals were by no means immune to the crisis.
(iii) Other Features
13. Other features of the bust part of the cycle included - • An unexpectedly strong link between declining share prices of institutions and depositor confidence in those institutions.
• Forced withdrawal of mortgage lenders from the market.
• Strong evidence of fraud.
• A loss of trust and confidence both by institutions in each other, and retail depositors in institutions.
• A growth in mortgage arrears and repossessions
Government Assistance
14. In very brief summary, the main action on the part of Governments or central banks around the world consisted of the provision of – • Equity ie capital
• Liquidity, including both enhanced central bank activity and quantitative easing
• Guarantees
• Low interest rates
• Enhanced deposit protection
• Help for specific markets. In the UK in the housing market, the price threshold for paying transactions tax (Stamp Duty) was increased, while various initiatives were introduced to help those with mortgage arrears.
• The maintenance of government spending (often involving increased levels of borrowing) at a time of reduced economic activity
• New legislation, particularly in the UK, to facilitate the orderly run down of failed institutions
Building Societies – an Introduction
15. Building societies are a specific form of mutual entity established under UK legislation. They are not companies. Their legislation forces them to obtain the majority of their funding from the retail savings market, and to undertake the majority of their lending in the residential housing market. Building societies have no external shareholders; they are owned collectively by their mortgage and investing customers and have the advantage of not having to pay dividends. Generally, this enables them to pay higher, and charge lower, rates of interest on their savings and mortgage
4 accounts than can their competitors. Their constitution also encourages them to concentrate on customer needs as this is the sole reason for their existence. Market research shows that building societies have a better record than their competitors in consistently paying good rates of interest; in achieving high customer satisfaction; and in customer perceptions of value for money, trust, treating customers fairly and willingness to recommend to friends and family. Finally, building society members, ie their customers, are able to express views, and vote, on issues such as the director remuneration report at building society AGMs.
The current situation facing building societies
16. Building societies have performed relatively well during the recession. The FSA said in June 2009, for example, in A Specialist Sourcebook for Building Societies: Enhanced Supervisory Guidance on Financial and Credit Risk Management –
“Although building societies, like banks, have been weakened by adverse economic and financial market conditions, the extent of that weakening has to date been less than that experienced by the banks – mainly because of the lower exposure to wholesale funding and complex financial instruments.”
17. Similarly, HM Treasury, in its White Paper Reforming Financial Markets published in July 2009, said that –
“The mutual sector has not been immune to the pressures caused by the contraction of global credit markets and the crisis that has ensued, particularly for those firms diversifying into new and high risk lending products – it is the Government’s view, however, that the traditional mutual model has, on the whole, stood up well.”
18. Overall, building societies pursued less adventurous lending policies than their competitors in the mortgage market in the run up to 2007 and their arrears figures are significantly less, proportionately, than the average for the whole market (and building societies remain committed to helping those in arrears in every way they can, viewing repossession as the very last resort in the vast majority of arrears cases).
19. Despite this building societies, like other institutions, are finding current market conditions challenging. In particular, there is now a limited flow of funds through the principal markets in which building societies operate. In 2006 deposit balances across all banks, building societies and National Savings & Investments rose by £77 billion. This year the figure is likely to be around £10 billion; all of this accounted for by interest credited to accounts. Discretionary deposit saving is likely to be negative. The BSA warned earlier this year that very low interest rates would reduce the incentive to save, and restrict the flow of funds to the mortgage market – unfortunately this prediction has proved to be correct.
20. In the UK mortgage market in 2006 net advances (ie advances after taking account of repayments) amounted to £110 billion. This year, the figure is likely to be around zero. Quantitative easing, designed partly to increase the flow of funds in the economy, has not resulted in new flows in these markets. Indeed, the evidence suggests that banks are hoarding these flows, with substantial increases in their cash held with the Bank of England (up from £31 billion in March 2009 to £136 billion in August), rather than using QE money to increase their lending.
21. Profitability is also sharply diminished. In 2008 building societies collectively made a profit of 16 pence for every £100 which they managed. Over the previous
5 few years the figure had been very stable at around 33 to 36 pence for every £100 of assets. The figures for 2008 were adversely affected by reduced interest rate margins, lower sales of insurance products (reducing the flow of commission payments), some provisions for loss, and notably, provisions for payments into the Financial Services Compensation Scheme, as building societies bore a significant proportion of the costs of bailing out the failed Bradford & Bingley bank and the Icelandic banks. Similarly, the mainstream banking sector is also suffering a sharp reduction in profitability. Profits of the biggest four UK banks (HSBC, Barclays, Lloyds Banking Group and RBS) fell by 78% in their UK retail banking business between the first halves of 2008 and 2009. (Source: bank half yearly statements, analysed by KPMG in UK Banks: Performance Benchmarking Survey, Half Year 2009, page15.)
22. Building societies and banks also suffer from conflicting pressures to increase capital, increase liquidity and to lend more (when funding markets are effectively closed). These ambitions are not compatible.
23. In particular, building societies now have to place between 20% and 25% of the funds they raise in low-yielding liquid assets; similarly, banks have been required by the authorities to increase the proportion of liquid assets that they hold. This has the desirable objective of making firms more resilient to any future funding crises. However, those funds allocated to liquidity cannot simultaneously be lent to customers, be they homebuyers or businesses.
24. Similarly, institutions are under pressure to hold increased levels of capital to cover the possibility that they might make further losses on the loans which they currently hold, or might hold in the future. Capital ratios can be increased, most obviously, by restricting the growth of the balance sheet and ensuring that any growth that does take place is concentrated on low risk lending, which requires less of a capital buffer against the possibility of loss. This is achieved in the mortgage market by asking borrowers for large deposits and not lending to individuals with blemished credit records. Falling house prices increase the potential losses that could arise in the event of repossession and this trend again requires more capital. Any institution ignoring these trends and increasing riskier lending faces the possibility of being downgraded by the credit-rating agencies, thus reducing the supply of wholesale funding further, increasing the cost of those funds that are available, and suffering a declining reputation in the retail market.
25. Building societies also face intense and, many would believe, unfair competition from the fully nationalised or majority Government owned banks, together with National Savings, all of which are perceived to have explicitly or implicitly a total Government guarantee. Furthermore, the Government’s Debt Management Office is replacing building societies (and banks) in the wholesale market. Local authorities, especially, used to lend significant sums to building societies (and banks) but have been withdrawing deposits from both sectors.
26. Finally, building society access to Government schemes such as the Credit Guarantee Scheme and the Asset Purchase Scheme are either not available or available on much more onerous terms than for banks.
27. Having made all these points it is important to bear in mind that all banks and building societies are different; not all are affected by the factors described above equally. The vast majority of building societies remain profitable, and will survive the current difficult environment.
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The Outlook
28. The outlook is one of slow recovery. The challenges described above are not open to easy, quick solutions. Rather, a period of retrenchment, debt repayment and limited new borrowing is likely throughout the private sector. Steps are likely to be taken to reduce public sector borrowing.
29. As far as the regulatory authorities are concerned, a fairer mechanism for funding the FSCS needs to be found – at the moment prudent organisations (including most building societies) bear a disproportionate share of the costs of bailing out failed institutions. In addition, a clear message from the authorities on their collective view on how to balance the conflicting pressures on liquidity, capital, and lending would be helpful. It will also be important to ensure that there is not too onerous a regulatory backlash that penalises the majority of well run institutions – the FSA is, for example, proposing a building society sourcebook that will restrict even the most prudently run societies in a way that will not be applied to banks.
30. Building societies are likely to “hunker down” for a year or two in these conditions - their corporate structure, not involving the payment of dividends to shareholders, enables them to do this - in the hope and expectation that they will be able to play an important role in the recovery in the housing market when this takes place in year or two’s time. Cost control has become even more important, and corporate governance standards need to be driven even higher. Nevertheless, building societies - and other financial mutuals - remain convinced that at a time of significant distrust of plc and nationalised banks, the mutual approach (despite recent difficulties) has much to commend it.
Building Societies Association 11 September 2009
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